Friday, August 28, 2009

Chamberlain's wife:"You glisten too brightly." Sanjuro:"Glisten?"Chamberlain's wife:"Yes, like a drawn sword." Sanjuro:"A drawn sword?"Chamberlain's wife:[Nods] "You're like a sword without a sheath. You cut well. But the best sword is kept in its sheath."

In the highly stylized Kabuki world that is investment banking, there are few documents more abstruse and impenetrable to common understanding than the engagement letter.

This is the contractual document, prepared by the investment banker and his or her legal department and ultimately co-signed by the client, which encompasses the terms under which the banker will work for the client on one or more particular transactions. As such, and as one might reasonably expect, the business terms of such an engagement are relatively straightforward:

Exactly what would you like us to do for you?

How long will we work on this for you?

How many shiny simoleons will you pay us for working on it?; and

What do we do if things go wrong?

In addition to the usual inclusion of a promise that the bankers won't sell your company's data down the river at the first opportunity—the hallowed confidentiality provision—there really isn't much need for a hell of a lot more in the letter. Find a deal, do it, get paid, and play nice along the way. Simple, right?

* * *

Sadly, we no longer live in prelapsarian times. Ever since the first in-house compliance lawyer slithered down the tree in the Garden of Eden carrying an apple and an Indemnification Provision in its mouth, investment banks' engagement letters have suffered the same legalistic blight that has afflicted every other area of business documentation. Now they are almost comically bloated and opaque fugues of defined terms, parenthetical meanderings, comprehensive itemizations of minor variations on picayune themes, and "provided, howevers":

This letter, when executed by the parties thereto, will constitute an agreement (the “Agreement”) between Company XYZ (the “Company”) and The Devil's Rejects, LLC (“Advisor”), pursuant to which the Company agrees to retain Advisor and Advisor agrees to be retained by the Company under the terms and conditions set forth below.

Responsibility is neatly encapsulated and evaded:

Neither Advisor nor any of its affiliates (nor any of their respective control persons, directors, officers, employees, or agents) shall be liable to the Company or to any other person claiming through the Company for any claim, loss, damage, liability, cost, or expense suffered by the Company or any such other person arising out of or related to Advisor’s engagement hereunder except for a claim, loss, or expense that arises primarily out of or is based primarily upon any action or failure to act by Advisor, other than an action or failure to act undertaken at the request or with the consent of the Company, that is found in a final judicial determination (or a settlement tantamount thereto) to constitute bad faith, willful misconduct, or gross negligence on the part of Advisor.

A close reader of such a contract might begin to wonder just which services exactly the investment bank is supposed to provide under its engagement:

The Company will furnish to Advisor such information as Advisor reasonably requests in connection with the performance of its services hereunder (all such information so furnished is referred to herein as the “Information”). The Company understands and agrees that Advisor, in performing its services hereunder, will use and rely upon the Information as well as publicly available information regarding the Company, the Target Company, and any other potential acquisition candidates and that Advisor does not assume responsibility for independent verification of any information, whether publicly available or otherwise furnished to it, concerning the Company, the Target Company, or any potential acquisition candidates, including, without limitation, any financial information, forecasts, or projections considered by Advisor in connection with the rendering of its services. Accordingly, Advisor shall be entitled to assume and rely upon the accuracy and completeness of all such information and is not required to conduct a physical inspection of any of the assets or liabilities of the Company, the Target Company, or any other entity. With respect to any financial forecasts and projections made available to Advisor by the Company and used by Advisor in its analysis, Advisor shall be entitled to assume that such forecasts and projections have been reasonably prepared upon bases reflecting the best currently available estimates and judgments of the management of the Company.

And that, by the way, is not the worst I have seen, not by a long shot.

Of course, engagement letters are written this way because they are authored and negotiated by lawyers. Lawyers whose job it is to maximize their own client's options, deniability, and wiggle room under the contract at the expense of their counterparty's. The businessmen and bankers who strike the original deal usually have a far more optimistic (some would say naive) view of the relationship, and high hopes the investment bank can help the company strike an attractive, well-priced deal in a reasonable amount of time. It is only when things go bad and the shit hits the fan that the parties begin to point fingers at each other, and the entire mess devolves into a particularly nasty cat fight. Lawyers draft and negotiate engagement letters with just this sort of scenario in mind. I suppose one shouldn't complain: that's what we pay them for.

* * *

As far as an investment bank goes, the truly important thing in an M&A deal is to get paid. Huge quantities of verbiage are shoehorned into engagement letters to delineate details on exactly when this will happen and how many greenbacks need to change hands. It is so important that many banks demand the client pay a fee upon completion of a deal substantially like the one contemplated in the agreement letter even if the bank's engagement has been terminated. This is called a fee "tail," and investment bankers will bargain hard for a tail of up to two years after termination of the original engagement. You can see their point of view: they want to get paid if their former client completes a deal like the one they advised them on within a set period of time. That way, the client is not tempted to get close to agreement, fire the banker, close the deal, and then refuse to pay just because the contract is dead.

You just can imagine how tickled this makes most clients (and their lawyers) feel when they see that little gem. The fee tail and the indemnification provisions—wherein the bank asks the client to protect it from any and all third party claims over the deal come Hell, high water, or four scary looking guys on horseback—are usually the most hotly negotiated terms in an engagement letter. Those are the areas where most disputes, if they do come, will come.

But here's the rub.

Lawyers for investment banks try to draft airtight, ironclad engagement contracts so, if worse comes to worse and the client breaches the agreement, they can sue them for specific performance and/or damages. But I ask you: what kind of fool of a service provider regularly sues its clients? A damn fool, that's who.

The ability to sue your client over breaches in an engagement contract is a nuclear option, at best. For one thing, you better have a pretty airtight legal case, or you are going to look like seventeen kinds of idiot when the judge throws your suit out of court. For another, clients talk, and you can rest assured the fact you are suing Bobby Joe for a little ol' M&A fee on some pissant acquisition is going to get around the Dallas Petroleum Club damn quick. You better hope everyone there thinks Bobby Joe is a lying prick and a complete dickwad, or you can bet your M&A workload in the energy sector is going to suffer a nasty spill going forward.

The only time it makes sense to sue a client over an engagement letter is when the client's behavior is clearly fraudulent, the client is disappearing or doesn't matter in some way, or the money involved is just too big to let go. For that reason, I have seen very few instances over my career where investment banks have taken their clients to court to enforce an engagement contract. (I actually testified on my employer's behalf in one such case years ago, but that client was a complete dickwad, so it made sense. We won.) Usually, the better part of valor—and the better business decision—is to tear up the engagement letter and chalk it up to experience. Most of the time that is the only effective way for an investment bank to buy its way back into the good graces of a frustrated and unhappy client anyway.

* * *

None of these motivating conditions apply in the case of recovering alcoholic struggling insurance company AIG or its majority owner, the Federal Reserve Board, however. Hence, I have to respectfully disagree with Michael Corkery at The Wall Street Journal. In an article today describing how AIG's new CEO is slowing down or postponing the raft of asset sales his predecessors initiated in an attempt to repay taxpayers and how this threatens a huge fee backlog for Wall Street, Mr. Corkery seems to take comfort that some of those fees are protected under contract:

To be sure, the banks may have pocketed many of these fees already or have contracts that AIG and the Federal Reserve, which is heading the restructuring effort, have to keep.

Fortunately, I do not work for any of the firms Mr. Corkery lists. If I did, I would find the existence of any such signed engagement letters very cold comfort indeed.

The prospect of suing the Government of the United States of America to collect a contracted fee on a nonexistent deal strikes me as one of the least intelligent decisions any major Wall Street investment bank could possibly consider nowadays.

Tuesday, August 11, 2009

Herewith do I present you, Dear Readers, 17 minutes, more or less, of Alain de Botton nattering on about meritocracy, justice, luck, envy, snobbery, and other foibles from the "human anthill," via that unnamed media organization which still refuses to pay lucrative royalties to Yours Truly for the use of his patented, copyrighted, and thoroughly well-known global sobriquet.

Perfect material for wasting time on a slow summer Tuesday and/or stimulating unused centers of reasoning within your brain, depending on your personal capabilities, receptivity, and preferences. I find de Botton's critique of the cult of meritocracy from the importance of happenstance in individuals' lives to be one of the more insightful nuggets within his talk. In this manner, his perspective is not unlike what I find to be one of the few useful strains of argument still emanating from that vast edifice of megalomanical pontification which used to go by the name of Nassim Taleb.

Notwithstanding any other bits of educational or morally enlightening value, I think one of the more entertaining parts was the fake headlines de Botton got the cheesy UK tabloid Sunday Sport to compose based on famous tragedies from the Western tradition. My favorite: the editors' catchy summation of Sophocles' Oedipus Rex as "Sex With Mum Was Blinding."

Friday, August 7, 2009

The utility of biography, Dr. Johnson argued, rests on the fact that we can enter by sympathy into situations in which others have found themselves. Parallel circumstances to which we can conform our minds shape every life. Even the great are not removed from the factors common to all: "We are all prompted by the same motives, all deceived by the same fallacies, all animated by hope, obstructed by danger, entangled by desire, and seduced by pleasure." I must confess that twenty years devoted to the biography of Newton have not in my case confirmed Dr. Johnson's dictum. The more I have studied him, the more Newton has receded from me. It has been my privilege at various times to know a number of brilliant men, men whom I acknowledge without hesitation to be my intellectual superiors. I have never, however, met one against whom I was unwilling to measure myself, so that it seemed reasonable to say that I was half as able as the person in question, or a third or a fourth, but in every case a finite fraction. The end result of my study of Newton has served to convince me that with him there is no measure. He has become for me wholly other, one of the tiny handful of supreme geniuses who have shaped the categories of the human intellect, a man not finally reducible to the criteria by which we comprehend our fellow beings, those parallel circumstances of Dr. Johnson.

— Richard S. Westfall, Never at Rest: A Biography of Isaac Newton1

Lest you be overawed by the towering, alien intellect of Mr. Westfall's great subject, O Intelligent and Humble Reader, do not forget that it was this same Isaac Newton who is known to have invested a large sum in stock of the South Sea Company near the peak of its bubble in 17202 and who was reported by his niece to have lost £20,000 (or £3 million in today's money) upon its ultimate collapse.

I can calculate the motions of the heavenly bodies, but not the madness of people.

* * *

With all due deference and respect to my learned colleagues in the study and practice of quantitative finance, I will side with Sir Isaac and state that we still have a great deal of work to do before we can confidently predict the madness of our markets.

But then, I'm just an old fogey who finished math at linear algebra and differential equations. WhatdoIknow?